When “Risk” Gets Real

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There are a lot of risks in the markets, but the really big risks occur when everyone (institutional investors, individual investors and other market players) gets on the same side of the trade (for instance, dot.com in 1999, or housing in 2006). This occurrence is difficult to see, but there are certainly signs.

The biggest sign for me is when people talk about redefining risk.

In ordinary circumstances, we can tease out lots of different market risks (Investopedia lists two categories and six basic risks). They are: Credit, Country, Currency, Interest Rate, Politics, and Market risks. These are the risks that really matter to a portfolio, because they matter to companies in operation. When people build “diversified” portfolios, they are blending these different risks together, in the hope of smoothing out their portfolio’s zigs and zags. And, in a normal environment and over long stretches of time, this works beautifully.

But when “new era” or “new paradigm” talk begins, we need to start to be a little careful. You could probably find a headline everyday that is claiming a “new era” is here. In specific sectors and small bits of the world, new eras are possible. The wheel started a new era of transportation, industrialization started a new era of production, the Internet started a new era in communication –new eras do happen. But they cannot revoke the fundamental laws of the market, which is why it is so important to understand those laws and have them built into your asset management framework.

For me, when every paper, magazine, radio program and cable show is claiming that the fundamental rules of business and economics have changed, the canary has already begun gasping for breath. This is the moment where “risk” gets real.

As unalloyed positive media reports continue rolling in, people gain confidence. As their confidence gets higher, they buy more, markets go up, and the headlines get even more positive. Without a reality check (a quick reference back to the fundamental laws) this process continues—markets build confidence, confidence builds markets, media discusses the “new paradigm”—until people are no longer concerned about the “real” risks mentioned above. They don’t care about interest rates, earnings, credit markets or politics. Greed sets in.

When people start worrying en masse about how much the market is up, or their neighbor is up, or some pseudo-advisor on CNBC is up relative to how little they are up; when they start worrying about NOT being in the market ENOUGH; and when they start worrying about the great returns that exist but they are not getting, the canary is lying quietly on its side on the bottom of the cage.

The canary might be in another part of the mine. The individual who is paid to watch the canary and sound the alarm may have left his post to use the restroom. But sure enough, the canary is no more. The goal for speculators is to no longer be on the wrong side of the trade as quickly as possible. And the selling begins. The speculator bases his/her (lets face it, usually his) entire investment process on the belief that they will see the canary first or at least earlier than most. For long term success, they must be first not just this time, but every time. The goal for investors should be to never have engaged in the silliness to begin with.

While speculators run for that rickety mineshaft elevator, which is far too small and slow for everyone to get out at once, investors effortlessly and brainlessly (though not without anxiety, because what if this time “IS” different) maintain their plan and their portfolios, add money as their plan has told them they should, and rebalance regularly. While speculators sell to avoid large losses and markets go down, investors pick up a few shares here and there in their dollar cost averaging and rebalancing programs.

The risk is real for everyone—the question is: are you speculating or are you investing? What is really going on?

The opinions voiced in this material do not necessarily reflect the views of LPL Financial and are for general information only and are not intended to provide specific advice or recommendations to any individual. For your individual investing needs, please see your investment professional regarding retirement planning.

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